Are cuts the answer to growing Czech public debt and an expanding deficit?
One phrase, fiscal responsibility, and one word, cuts, dominate Czech economic and political life following elections to the lower house at the end of May. The right-wing coalition government in the making has pledged the former, with public spending on the block in all post-election rhetoric. We look at the rationale behind the obsession with cutting public spending, and whether the likely next Czech government is choosing the right path.
Ahead of the Czech lower house elections there was no argument about cutting the growing Czech budget deficit. The two main parties, the Social Democrats and Civic Democrats, both promised to almost halve last year’s budget deficit of 5.9 percent of Gross Domestic Product to 3.0 percent by the end of their four year term in office, thereby meeting one of the main criteria for adopting the single currency euro. Some, such as the new conservative party, TOP 09, wanted to go even further with a target to balance the books so that state revenues would equal public spending. Fellow new party Public Affairs promised a war against waste in its more centrist, if confusing, economic stance.
The big difference between the parties was how to get to their goals. The Social Democrats believed they could get there with some increases in direct tax combined with an active state encouraging economic growth. It said this would boost tax and other income and cut the amount of public spending on unemployment and social payments.
The right-wing parties offered the prudent housekeeper model, shying away from higher taxes on individuals and companies and offering a slimmed down state and cuts in public spending. Voters seem to have plumbed for the second choice.
Although, the left-right debate naturally revolves around the size of the state and thus what it spends, the Czech election focus on debt and deficit — with warnings of a Greek-style economic tragedy — are a bit puzzling when the furore makes space for the facts. Czech overall government debt is rising but is still around half the average European level and the deficit was climbing, but hardly out of control.
David Marek is chief economist at Prague-based Patria Finance. He says the concerns about Czech public finance are more based on looming rather than immediate problems. And he adds there is no threat that the influential international rating agencies would downgrade the country’s risk rating soon.
“So far we are not in a position that we may face any rating downgrade or pressure from financial markets. Fortunately we still have a relatively low level of government debt in relation to GDP. So we have time to solve our fiscal problems without additional costs as we can see in the case of Greece, Spain, Ireland and other countries. So I would not be afraid of any immediate pressure from financial markets on Czech government bonds.”
Mr. Marek backs what appears to the main drift of the centre-right parties to set their sights on cutting public spending.
“As a small open economy we need to keep our competitiveness as far as possible. So it would be a mistake to increase direct taxes, corporate income tax and personal taxes. On the other hand, there is still room to increase the lower bracket of VAT and excise duties. But the main burden of fiscal consolidation should lie on expenditure cuts.”
The government, he says, needs the fiscal elbow room to pave the way for reform measures that have been put off in the past, for instance the re-drawing of pension policy to take account of the demographic challenge of ever fewer workers paying for ever more pensioners.
Martin Fassmann is the head of the economic section at the Czech and Moravian Confederation of Trades Unions. He believes that it is too early to be preparing public spending cuts when the Czech Republic and the rest of Europe are not certain of coming out of recession. He warns that unemployment, while on the slide over the past few months, could still rebound and start heading for nine or 10 percent when school leavers and students end their studies.
And Mr. Fassmann charges the would-be government parties of ignoring growth as a factor in improving the budget deficit.
“Of course, economic growth is an instrument for, let’s say, improving the budget deficit. Every percentage point of extra nominal economic growth means around 12 to 13 billion crowns in higher tax receipts. But no-one is talking about economic growth, just about cuts, and cuts do not bring about prosperity.”
The trades unions together with the biggest Czech employers’ association had drawn up a 38-point plan to help boost economic growth, for example by launching the construction of around 50,000 flats as part of a social housing drive. But Martin Fassmann reckons these already diluted plans will hit the buffers under a future centre-right government.
Pavel Mertlík is a former Social Democrat finance minister and now chief economist at Raiffeisen Bank’s Czech operations. He says action is needed to tackle the Czech debt and deficit overload. But he warns that this should deal with an eroded tax base as well as excess spending.
Mr. Mertlík adds that the spending cuts envisaged by the incoming coalition could cut economic growth next year from 2.5 percent to 2.0 percent.
The trades unions’ Martin Fassmann has a more fundamental criticism of the whole Czech tax system and that is the many tax exemptions built in from the early 1990s. He says recent tax reforms have eroded the tax base rather than strengthening it. Since 2007, a good year for the state coffers, tax revenue has consistently fallen from companies and individuals and not been made up by a small rise in income from sales and excise taxes.
Added to that, he says the tax burden is unfairly distributed with most of it falling on the shoulders of those who are employed and the self-employed escaping almost unscathed as a result of the generous tax deductions they can claim.
“The specific nature of the Czech tax system is that different categories of people are taxed in a diametrically different way. The problem that has been highlighted by the Organisation for Economic Cooperation and Development for example is that self-employed people have exceptional tax advantages compared with the employed. And this has created the speculative shift to self-employment from employment, resulting in tens of billions of crowns escaping the public budget. This problem has to be cleared up.”
Indeed, the OECD calls for this distortion to be addressed. But while promises to do so were included in the Social Democrats’ election manifesto they were absent elsewhere. One reason might be the simple fact that the generosity of the Czech system means around 20 percent of the workforce has self employed status. In the latter-day home of capitalism, the United States, it is around a third of that total. This is therefore a large, and mostly right-learning, section of society.
